Many business entities provide owners with personal liability protection. As a result, ownership in these entities is not personally liable for business debts, obligations or acts. This personal liability protection, however, may be legally disregarded in certain circumstances according to a theory of veil piercing. This initial blog entry examines the current state of veil-piercing law in Colorado in order to summarize those points most important for small business owners.
Although veil-piercing theory initially developed under corporate law, the same principles have been brought to bear on other limited liability entities (LLEs). For example, in 2016, the Colorado Supreme Court, citing the language of the LLC statute, held that "the case law governing corporate veil-piercing applies to disregarding the LLC form as well."FN1 As a result of this and similar cases, the following points apply to any sort of LLE - not just corporations.
The first point is that veil piercing is supposed to be the rare exception, and not the rule. The Colorado Supreme Court just last year reiterated the Court's long held view that the "separate status" of an LLE "normally insulates... [the] shareholders from personal liability for the debts of the corporation" and "only extraordinary circumstances justify disregarding the corporate entity to impose personal liability."FN2 However, this was a case, like many others, where this Court or another found veil piercing warranted.
Here the Court determined that the LLC was simply the "alter ego" of its owner. In making this determination the Court looked at eight (8) factors:
Whether the LLE operates as a distinct business entity;
Whether funds and assets are commingled;
Whether adequate corporate records are maintained;
Whether the nature and form of the entity's ownership and control facilitate misuse by an insider;
Whether the business is thinly capitalized;
Whether the corporation is used as a 'mere shell;'
Whether shareholders disregard legal formalities; and
Whether corporate funds or assets are used for non-corporate purposes.FN3
Thus, the second point is that veil piercing does happen, and it happens when business owners are insufficiently respectful, in practice, of the separateness of their LLE.
However, a finding that an LLE is the alter ego of its owner(s) is not enough by itself to support veil piercing. Instead, the LLE must also be "used to shield a dominant shareholder's improprieties."FN4 This the third point; veil piercing occurs because of misconduct, often fraud, conducted through the LLE.
To capture each of these elements, the Tenth Circuit has adopted a two-prong test: "(i) was there such unity of interest and lack of respect given to the separate identity of the corporation by its shareholders that the personalities and assets of the corporation and the individual are indistinct, and (ii) would adherence to the corporate fiction sanction a fraud, promote injustice, or lead to an evasion of legal obligations."FN5
The first prong captures the concern that an LLE may be used as an alter ego, and the second addresses the concern about the misuse of the LLE to perpetuate wrongdoing.
But the 10th Circuit also attached important conditions to the second of these prongs: First, the fraud or injustice had to stem from the fact that the LLE was treated merely as an alter ego. And, second, "the individual who is sought to be charged personally with corporate liability must have shared in the moral culpability or injustice that is found to satisfy the second prong of the test."FN6 Thus, the fourth point is that there must be a connection between the use of an LLE as an alter ego and the alleged misconduct. Otherwise, it is nevertheless appropriate to insulate shareholders from liability.
Another thing to note here is that veil-piercing theory may not only allow courts to disregard the personal liability protection of LLEs, but it may also allow for the reverse situation - where alter ego misuse of an LLE may allow creditors to seek business funds and assets to satisfy the personal obligations of individual owners. Depending on an individual owner's situation, this may be an even more important reason to avoid a situation likely to lead to veil piercing.
One final point is that the alter-ego misuse of an LLE may also subject an individual owner to the jurisdiction of a court that otherwise would not have had it but for the LLE's business contacts. Earlier this year the U.S. District Court of Colorado allowed just this very thing to happen.FN7
More will be written about veil piercing in future posts. If you need legal assistance with matters related to business formation or ownership agreements, please Reach out, Today!